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Easy Al's 1% Wonder

Next are housing costs. This is the biggie, weighing in at about 40% of the actual CPI and closer to half of the core index. Now, everyone knows that housing prices and operating costs such as insurance and taxes have appreciated strongly in the past few years, something like 5% to 7% annually. Clearly this component must be pushing up the inflation numbers. Well, not really. The government doesn't use housing prices and home-operating costs, but rather a quite interesting concept called rent and owner's equivalent rent.

An overbuilding of apartments and a secular shift toward home ownership have depressed the rental market. About 70% of households own homes today and are not directly impacted by rents. However, the government doesn't revert to actual housing costs here. Instead, it attempts to estimate what homeowners' rent would be if they were renting their primary residence.

But very few single-family homes participate in an active rental market. So, basically, the government makes it up. In the December 2003 CPI report, the total rent component of the CPI (rent plus owner's equivalent rent) rose 2.2%, a 20-year low. Even adjusting for lower financing costs, I have a difficult time believing that 2.2% number, as does my real estate agent.

But it gets even better. When energy prices increase significantly, as they recently have, shelter prices decline. That's because the rent/owner's equivalent rent concept implies a heating/cooling contract. Because actual rent paid is somewhat sticky, rising energy costs decrease the value of the rent component. For example, the housing part of the CPI was up 2.1% in February year over year. But in the core CPI, spiking energy costs lowered the change to 1.6%. With this methodology, $100 for a barrel of oil would turn the rent/OER concept negative in and of itself. How absurd is that?

Jim Grant, proprietor of Grant's Interest Rate Observer, has calculated the CPI substituting a housing price index for owner's equivalent rent. As his chart reveals, inflation is running around 3.5% instead of the 2.2% core number reported by the government. This kind of number seems more accurate to my personal income statement.

A Different CPI Perspective
Here's what it looks like with real housing prices
Source: Bureau of Labor Statistics, Freddie Mac

It gets even better. The people at the Bureau of Labor Statistics make qualitative adjustments to goods when they perceive improvements. That is, they adjust the base price of a good or service upward due to quality improvements. This action then understates the increase because of price inflation of the good. The BLS does this with more than 50% of the CPI components!

They do not, however, adjust base pricing lower for qualitative deterioration in a product. Steve Leuthold had a great example in a publication recently. Since 1979, the average price of a new car has risen from $6,847 to $27,940, or 308%. But the CPI-adjusted series from the same date reveals only a 71% increase. Therefore, about $16,000 of the $21,000 increase is due to quality improvements and not in price inflation. Ironically, the repair bills aren't deflating. The BLS is now attempting to expand the number of CPI categories adjusted for quality improvement.
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